PDF My Top 5 Rules for Successful Debit Spread Trading

My Top 5 Rules for Successful Debit Spread Trading

Trade with Lower Cost and Create More Consistency in Your Options Portfolio

Price Headley, CFA, CMT

TABLE OF CONTENTS: How Debit Spreads Give You Growth AND Income Potential Rule #1. Buy In-The-Money and Sell At or Out-Of-The-Money Rule #2. Sell More Time Premium Than You Buy Rule #3. Profit Taking in Pieces Increases Win Percentage Rule #4. Don't Be Greedy ? Favor Early Profit Taking Rule #5. Trade in Pairs

How Debit Spreads Give You Growth AND Income Potential

If you've ever bought an option before, you know that one of the challenges of trading a time-limited asset is paying a "time premium" and overcoming the loss of time. And yet as a trader, I still see plenty of opportunities to take advantage of trends on various time frames, from quick moves over a few days to "swing trading" moves over several weeks. So how can you actually place time on your side in the options game? It's not by just selling options, as that can be profitable, but many traders have seen how a small number of trades can cause you lots of trouble in option selling if a stock or market moves sharply against you.

The answer that meets nicely in the middle ? profiting from the growth potential of catching a piece of an existing trend, while lowering your total cost per contract and paying no net time in your options ? is Debit Spreads. You may have heard them called Vertical Spreads, or Bull Call Spreads or Bear Put Spreads.

A Debit Spread still requires a cash outlay for the trade, similar to purchasing a Call or Put. However, you are also selling another option in the same underlying instrument and same expiration (month or week), but with a different strike price.

For a bullish spread, you are buying one Call and selling another Call with a higher strike price against it. This is done simultaneously as a spread order ? we do this with a limit entry price. We pay a certain price (or debit) for this trade, just as you would with buying a Call or Put ? with significant differences and advantages to the `2-legged' trade.

First, let's explore what types of options I like to purchase when I anticipate a big short-term directional trend move and what types of options to sell against that.

Rule #1. Buy In-The-Money and Sell At or Out-Of-The-Money

You of course want to find a healthy directional trend (I use technical analysis and systemized trading rules in my Smart Options portfolio, where I do a weekly video explaining various forms of technical analysis to my subscribers) and I want to focus you on the proper principles to construct an effective debit spread, where time is no longer your enemy. Now, we can place time on your side when done correctly with the Debit Spread.

I first want to buy an "In-The-Money" or ITM option as my base, in order to create a "stock substitute" position. For example, say you have XYZ stock trading a $100 per share. If you buy 100 shares of stock, that would cost you $10,000 up front. Instead I can buy a 95 strike call with 1 month before expiration for say, $600. That 1 options contract controls the same 100 shares of stock for just 6% of the stock cost. Of course, if you only bought the ITM option, you are looking at an intrinsic value of $500, and an extrinsic or "time value" remaining of $100. If the stock fails to move, you could be kissing that $100 goodbye in a month in a flat scenario.

Here's where I add a second layer to the initial ITM trade to turn it into a Debit Spread. For example, say I think the stock will go to 102 or higher in a month, for a 2% gain the stock. I could be conservative and sell the at-the-money (ATM) 100 call 1 month out for $300, or I could be a bit more aggressive and sell the 1-month 102 call for $200. Let's look at both scenarios.

The conservative income-only trader is looking to maximize the time premium collected, in this case lowering the cost on the 95 call down from $600 to a net outlay of $300, cutting the total cost by 50%. That reduction in the net price per contract is the primary advantage of debit spreads. The main downside of the Debit Spread is that you cap your upside, in this case at a $200 maximum gain (100 strike sold ? 95 strike bought = $500 max gain minus $300 cost per spread

contract). So for a percentage return, your maximum profit would be +67% ($500 max/$300 cost ... and of course you should factor in your commissions. Here in this report we are not counting commissions for easier understanding).

On the more aggressive alternative, you could sell the 102 call to give yourself more growth potential on the upside. The trade-off is you collect less time premium up front, lowering your net cost to $400 vs. the original $600, a 33% reduction in your risk per contract. But now your maximum gain potential at 102 or higher at the options' expiration is $700 (102 strike sold ? 95 strike purchased). So your maximum gain percentage at 102 or higher in this case is +75% (700/400).

The entry and exit for the Debit Spread is done as one limit order (we don't recommend market orders for spreads) and can be easily placed with your broker or on your trading platform. Check with your broker to make sure your account is approved for Debit Spread trading, which is typically simple to achieve because these are limited-risk trades.

Here's an example of a 95/100 call debit spread on Honeywell (HON), courtesy of :

Note that this HON example, and for Debit Spreads in general, you don't want to just "hold and hope" as you can lose your full cash outlay ? exactly the same as straight Call and Put buying. The odds of a maximum profit over 100 are much higher than the risk of a full loss, but we still want to control risk effectively. We'll cover rules for exits shortly.

All the broker will require in terms of margin or cash is the initial debit you pay. Since we are both buying and selling an option at the same time (with the same expiration date but different strike prices), this can offer several advantages to regular call and put buying that we'll delve into later in this report.

There are other advantages to adding a premium-selling element into your options trading portfolio. It's important to remember that for every option buyer there is a seller of that exact contract ? generally it will be a Market Maker on the other side of the trade. And just as you don't always want to be Bullish (or Bearish) in your trading, you also don't always just want to be buying options and paying for time premium.

So by selling an option against the purchase to form a limited-risk Debit Spread, you incorporate option selling into your trading. And just as I prefer deep ITM option buying, I also prefer to sell Out-Of-The-Money (OTM) and sometimes AtThe-Money (ATM) options against the ITM buy side. Both ATM and OTM options are made up of 100% time premium, priced based on the volatility of the underlying stock (or "Vega") and the time remaining (also called "Theta").

So with a Debit Spread strategy, you gain the benefit of selling an option against the in-the-money option you purchase, in a limited-risk environment. What other benefits does this strategy offer, and how does it differ from a straight option purchase in terms of risk/reward?

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